Ch 13

The Open Economy Revisited: The Mundell–Fleming

Model and the Exchange-Rate Regime.
13-1 The Mundell–Fleming Model
“the dominant policy paradigm for studying open-economy monetary and fiscal policy.”

The Key Assumption: Small Open Economy with Perfect Capital Mobility

this assumption means that the interest rate in this economy r is

determined by the world interest rate r*.

The Goods Market and the IS Curve

If e nominal exc rate, then ɛ (real exc rate)
= eP/P*
Consumption depends positively on disposable income Y-T. Investment depends (P = domestic price, P* = Foreign price)
negatively on the interest rate. Net exports depend negatively on the exchange
rate e. As before, we define the exchange rate e as the amount of foreign currency
per unit of domestic currency; for example, e might be 100 yen per dollar.
If domestic currency rise, ɛ rises.
The Money Market and the LM Curve

This equation states that the supply of real money balances M/P equals the
demand L(r, Y). The demand for real balances depends negatively on the interest
rate and positively on income. The money supply M is an exogenous variable
controlled by the central bank, and because the Mundell–Fleming model is
designed to analyze short-run fluctuations, the price level P is also assumed to be
exogenously fixed.

Once again, we add the assumption that the domestic interest rate equals
the world interest rate,
Putting the Pieces Together

goods market The endogenous variables are income Y and the exchange
Money market rate e.